Why pay for money you'll never use?

When taking out a 30-year fixed-rate mortgage, homeowners pay premiums to freeze their rates for the next three decades. But most people change their original home loan, either by moving or refinancing, and thus pay more for their first mortgage than necessary.

As interest rates on long-term fixed-rate mortgages rise, an increasing number of homeowners are considering adjustable-rate mortgages, or ARMs. During the week of March 22, ARMs accounted for 16.5% of loan originations, up from 14.5% during the week of Feb. 22, according to the Mortgage Bankers Association of America (MBAA). This coincides with a rise in fixed mortgage rates, which jumped from November's low in the mid-6% range to today's rates above 7%.

In a fixed-rate mortgage, lenders charge extra to hedge against inflation. But with an ARM, rates periodically change, tracking inflation, and this enables lenders to charge lower initial rates. Indeed, the current average rate, including points [finance charges paid by the borrower at the beginning of the loan] , on a 30-year fixed-rate mortgage was 7.12%, whereas the rate for a 1-year ARM was 5.54%, according to Bankrate.com.

As a result, homeowners who think they'll be moving or changing their loans within the next seven years should consider ARMs, especially hybrid ARMs, which have an initial fixed rate that lasts up to 10 years before changing. "It's significantly less expensive than the 30-year, and most people do not keep their loans 30 years, so why pay a premium for a 30-year mortgage?" says Ray Brown, co-author of Mortgages for Dummies.

In fact, the median age of a refinanced loan was just 3.1 years in the fourth quarter of 2001, according to Freddie Mac (FRE:NYSE ). "The conventional wisdom in the past was loans lasted seven years, but with all the refinancing in the last year and in 1998, I would guess that average loan is down to five years by now," says Phil Colling, economist in the MBAA's research and business development department.

Nonetheless, long-term fixed-rate mortgages remain the dominant product, accounting for 88% of all loan originations last year, according to the MBAA. Homeowners prefer fixed-rate mortgages because they are free of the risk of rising rates, requiring the same amount each month. "They're a no-brainer," says Brown. "It's like getting a goldfish as opposed to a dog."

How ARMs Work

An ARM is more complicated. Its rate has two components: the index and the margin. The index is the rate of a short-term maturity, such as the one-year Treasury bond or six-month certificate of deposit. The margin is a static percentage, usually around 2.5%, which is added to the index to produce the fully indexed rate -- the one you pay.

To protect consumers, ARMs limit the amount that the interest rate can change, usually no more than 2% annually and 6% over the loan term.

Hybrid ARMs offer homeowners a unique advantage because they adjust like an ARM but have an initial fixed rate for one, three, five, seven or 10 years. (For example, under a 5/1 ARM, rates don't change for the first five years.) As a result, people moving before the adjustment get lower rates without taking on any risk. "It essentially functions as a fixed-rate mortgage while they're in the home," says Greg McBride, financial analyst with Bankrate.com.

Before it adjusts, a 5/1 ARM can save a bundle over a 30-year fixed-rate mortgage. The lowest rate on a 5/1 ARM with no points was 6%, while a 30-year fixed mortgage with no points had a rate of 6.87%, according to Bankrate.com. On a $200,000 mortgage, you would have paid $8,735.85 less in interest on the 5/1 ARM after five years than you would have on the 30-year fixed-rate.

Once the rate begins to adjust, an ARM's fully indexed rate could rise or fall dramatically. In the past decade, the fully indexed rate on an ARM with a margin of 2.5% added to the one-year Treasury rate was below 6% three times, but above 8% four times. The trick is to make sure you're out of the home, or the loan, before rates rise. "In the end, a lot of this comes back to the time horizon," McBride says. "Those savings go out the window if you have a mortgage that ratchets up in later years."

Who Needs ARMs?

Therefore, ARMs are best for homeowners who know they'll be moving within the next seven years, such as military personnel or executives who frequently relocate. New homeowners, especially newlyweds with starter homes, are also good candidates, because they'll need larger homes if their family grows. "If you get married and start adding kids, that studio isn't going to work anymore," Brown says.

And with home values near record highs, homeowners struggling to afford a home should look into ARMs to increase buying power. "If you're in the mid-Atlantic, Los Angeles, San Francisco or any city on the eastern seaboard, then you might get some advantages from the lower rate on an ARM," says Lisa Applegate, director of marketing for Fannie Mae (FNM:NYSE ).

Long-term homeowners who don't mind fluctuating payments and additional risk could take a chance on a hybrid loan. But check out the worst-case scenario and see if you can make the monthly payment. "This is a roll of the dice," McBride says. "You're subjecting yourself to the whim of interest rates at the time."

To be sure, those uncertain of whether they'll be moving in seven years should think twice before leaping into an ARM -- especially when 30-year fixed-rate mortgages are below their historical average of 8%. "This can't be stressed enough. How long are you going to be in your house?" Applegate says. "Thirty-years are at such lows, consumers should look at them still."

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